Transcript Economics and Law Lecture 2 Ross Anderson What do economists study? • 17th century France: land, labour, produce • 18th century Britain: explanation of.

Economics and Law
Lecture 2
Ross Anderson
What do economists study?
• 17th century France: land, labour, produce
• 18th century Britain: explanation of growing trade
and the industrial revolution, starting with Adam
Smith’s ‘Wealth of Nations’
– Specialisation leads to productivity gains
– ‘Invisible hand’ – equilibrium arising from selfinterested striving of millions of people
– Theory of markets and value extended to labour and
capital too
• 19th century ‘marginalist revolution’ made all this
rigorous leading to Marshallian synthesis
What do economists study? (2)
• Late 19th century: Marx’s theories of poverty,
oppression and inevitable revolution
• Monopoly as the big problem: antitrust law
• 1930s: persistent unemployment of the Great
Depression
• 1970s: how to explain and cope with inflation
• 1970s/80s: asymmetric information
• 1990s: other factors in IT goods/services markets
• Now: huge diversity of subjects (healthcare,
insurance, security, environment …) but a core of
common tools and concepts
Roadmap
• Economics as a subject is traditionally made up of
macroeconomics, microeconomics and specialised
topics
• ‘Macro’ is about the performance and structure of
the global economy or a nation or region. It’s
about models of employment, inflation, growth,
investment, savings, credit, exchange rates,
GNP…
• We will touch on this only briefly
Roadmap (2)
• ‘Micro’ is about how individuals and firms react
to incentives, how market mechanisms establish
prices, and the circumstances in which markets
can fail
• Special topics of interest to computer scientists &
engineers include the economics of information,
the economics of dependability, and behavioural
economics (where econics meets psychology)
• Our tools range from mathematical models to
empirical social science
Example – theory
• Example of a model of how incentives work:
George Akerlof “The Market for Lemons”
– 100 used cars on the market in a town: 50 ‘plums’
worth $2000 and 50 ‘lemons’ worth $1000
– Only the sellers know which is which
– What’s the equilibrium price?
• Many wider implications: why old people can’t
get affordable insurance, why bad security
products drive out good ones, why Cambridge
degrees are valuable …
Example – empirical research
• Todd Kendall, “Pornography, rape and the
Internet” (2007)
– Internet uptake went at different speeds in different US
states
– What crimes were correlated?
– Rape and prostitution went down, while ‘runaways’
went up
– The first two had significance concentrated among 1524yo males
• For more examples of this, see “Freakonomics”
Prices and markets
• As an introduction to theories of prices, consumers
and markets, consider an idealised market for flats
in Cambridge
• Assume only two types – one-bed flats in town, or
house-shares in Chesterton. People who can afford
flats will rent them, and those who can’t will get
house-shares instead
• Assume that there are 1000 flats to rent, and that
people vary in their ability / willingness to pay
Accommodation market
• So there might be 1 person prepared to pay £2000, 300
prepared to pay £1000, 1000 prepared to pay £500…
• With 1000 flats to let, the market equilibrium price p* is
where the supply and demand curves cross, i.e. £500
Monopoly
• If the market is rigged, might restrict supply – 800 flats at
£700 pm can earn more than 1000 at £500 pm
• Intuitively, this is inefficient! (empty flats which people
would pay to rent)
• How can we formalise this?
Efficiency
• A monopolist might leave some flats empty
despite there being people who’d pay for them
• Definitions
– A Pareto improvement is a way to make some people
better off without making anyone worse off
– A Pareto efficient allocation is such that no Pareto
improvement is possible
• This is weak: pure monarchy and pure
communism are both Pareto efficient!
• Anyway, is there any way for the monopolist to
find a Pareto efficient allocation?
Discriminating monopolist
• If you know what everyone can pay, charge them just that!
• This arrangement is Pareto efficient!
• The monopolist captures all the consumer surplus …
Consumer surplus
• Consumer surplus is the total amount people saved on
their reservation price
• Ordinary monopoly: green area left to consumers
• The monopolist diminished surplus by A and B
• The discriminating monopolist gets the lot!
Monopoly and technology
• Monopolies are common in the information goods
and services industries
• We’ll study why in some detail later
• For now, monopolists have a strong incentive to
price discriminate so as to mop up all the available
surplus
• Hence the many prices of Vista!
• But it’s not just tech. Think airline tickets, cars, and
even food.
• So what factors determine the structure of markets?
Basic consumer theory
• Examines mechanisms of choice
• Consumers choose ‘best’ bundle of goods they can afford
• Most of the time, two goods are enough – say books versus
everything else
• Assuming a budget constraint m, p1x1 + p2x2 ≤ m
• This gives a line on which choices must lie
Preferences
• We draw ‘indifference curves’ or ‘isoquants’ joining
mutually indifferent points – that is, where the consumer
prefers bundle (x1, x2) equally to (y1, y2)
• We assume they’re well behaved – the curves don’t cross.
I.e. if (x1, x2) is preferred when (y1, y2) is affordable, then
when (y1, y2) is preferred, (x1, x2) is not affordable (the
‘weak axiom of revealed preference’)
Substitutes
• Sometimes I just don’t care at all whether I have
good 1 or good 2
• E.g.: Tesco’s sugar or Sainsbury’s sugar
• Such goods are called substitutes
Complements
• Sometimes I want exactly the same quantity of
good 1 and good 2
• E.g. left shoes and right shoes
• Such goods are called complements
Bads
• There are some goods I’d rather avoid!
• But sometimes I have to consume some of a bad
in order to enjoy some of a good
Marginal rate of substitution
• The tangent to an isoquant gives the marginal rate of
substitution (MRS)
• This is the exchange rate at which the consumer will trade
the two: MRS = x1/x2
• Comvex curves: you’re more likely to trade the good if
you have more of it
Diminishing MRS
• The more you have of x1 relative to x2, the more
likely you are to trade x1 for x2, in the strictly
convex case
• I.e. you become less willing to pay for ‘one more’
Utility
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Often indifference curves can be parametrised
Marginal utility MU1 = dU/dx1
Then MRS = -MU1/MU2
Utility functions can be useful for describing consumer
choices
• They can often be inferred from shopping behaviour, and
answer questions about the value of better / faster / …
Cobb-Douglas utility
• Commonly used: U(x1, x2) = x1cx2d
• If the utility is believed to depend on a number of
observed factors, take logarithms and look for a fit
The marginalist revolution
• Until 1871, no-one had a good theory of supply
and demand. Why are essentials like water cheap,
while diamonds are expensive?
• Now we know: the value of the last and least
wanted addition to your consumption of a good
sets its value to you
• Discovered by Karl Menger, Stanley Jevons, 1871
• Shifted thinking from costs of production to
demand, and led to ‘classical synthesis’ of
Marshall and others - interlocking models of
consumption, production, labout, finance etc in a
world of free competition
Concrete example
• Suppose a local coal market in 1840 had three
typical suppliers / customers
Sea coal gathering 8s
Blacksmiths
15s
Small deep mine
5s
Households
8s
Open-case mine
2s
Export
3s
• The market price determines who produces and
who consumes
• It’s determined by the marginal transaction
• It fluctuates with demand (weather) and can
evolve in the long term with tech, investment…